In late March, SEC Chief Accountant, James Schnurr, delivered remarks before the 12th Annual Life Sciences Accounting and Reporting Congress. The remarks addressed the new revenue recognition standard and internal control over financial reporting as applied in particular to life sciences companies, and also cautioned companies regarding non-GAAP financial measures.
Revenue recognition policies
First, Schnurr reminded the audience that new revenue recognition standard reflects the convergence of both U.S. GAAP and IFRS revenue standards and is designed to improve existing revenue requirements by eliminating industry-specific guidance, providing a more robust framework for addressing revenue issues and requiring additional disclosures. However, the impact of the new standard will differ from industry to industry. Although reporting under the new standard does not begin for most companies until 2018, the new standard will still be relevant now for many companies that elect to adopt the full-retrospective approach, which will require a look back under the new standard to 2016.
The new standard will require judgments by the issuer that will subsequently be evaluated by others, including auditors, investors and regulators. Schnurr encourages “companies to develop the judgments with appropriate knowledge of the new standard and a careful assessment of all relevant facts and circumstances surrounding their transactions. The assessment will often need to include an understanding of the contract terms (both written and oral), the economic substance of the arrangement, and attention to any contingencies such as those that can impact amounts recognized. Of course, documentation of the judgments will be critical to the application of the standard and should be reflective of the complexity and materiality of the arrangement.”
With regard to the application of the new standard in the life sciences industry, Schnurr singled out three areas: R&D arrangements, variable pricing terms (such as milestones) and rights of return.
- According to Schnurr, research and development arrangements “highlight an important scoping decision — if the arrangement is a collaboration, the new revenue guidance does not apply. If, on the other hand, the arrangement represents a contract with a customer (because, as an example, the company is being paid by a third party to conduct research on their behalf), the new guidance would apply. Further, some arrangements may include both a contract for collaboration and a contract for the transfer of goods and services to a customer; in this case, the arrangement may be partially in the scope of the new standard. This example illustrates the need for companies to carefully analyze their arrangements and evaluate them in the context of the scope of the revenue standard, which further defines when an arrangement should, and should not, be reported as revenue.”
- With regard to variable pricing terms common in R&D and royalty contracts, the new revenue guidance provides that “variable pricing terms, such as performance bonuses, milestone payments, and guarantees, will need to be re-evaluated as the timing of revenue recognition and content of disclosures could differ as compared to current U.S. GAAP. Because the new guidance does not permit unconstrained recognition, there is an important judgment about the likelihood of revenue reversal that must be made prior to recognizing revenue.”
- Also common in the life sciences industry, he observes, are rights of return, agreements to cover distributor carrying costs, guarantees of distributor profits, and other concessions. These types of arrangements must be carefully evaluated “to determine the appropriate timing and amount of revenue recognition. The core principle of the new revenue recognition standard is that companies will recognize revenue to depict the transfer of promised goods to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods. [Schnurr expects] management to implement — and the audit committee to oversee — controls to prevent the inappropriate recognition and reporting when a company sells products through a distribution network. The SEC staff will continue to monitor the sales practices and reporting of these types of arrangements.”
“Transition resource groups,” which were formed to solicit, analyze and discuss issues arising out of implementation of the new revenue guidance, are observed by the SEC staff, and, Schnurr asserts, the staff “will be informed by the TRG discussions when evaluating the reasonableness of registrant revenue recognition policies, whether established under U.S. GAAP or IFRS.” Therefore, Schnurr expects companies “to monitor the TRG discussions and meeting minutes to inform their selection and implementation of reasonable policies,” and, if a company intends to implement a policy that is “inconsistent with TRG discussions,” Schnurr encourages the company to consult with the Office of the Chief Accountant.
The status of implementation by companies appears to continue to be a problem, particularly because implementation “requires significant effort by companies, including analyzing contracts and designing new systems, processes and controls.” Surveys indicate that many companies are lagging in implementation, and auditors have an obligation to bring any concerns about implementation to the attention of the audit committee. (See this PubCo post.) Industry groups, which play an important role in educating constituents on the application of the new standard, are encouraged “to identify issues and seek consistency in material conclusions. Where consistency is not achieved by task forces, I encourage members to escalate issues to the TRG for further discussion.” Issues can also be raised with OCA.
Schnurr expects that both investors and the SEC staff will be monitoring and reviewing companies’ required disclosure regarding the anticipated effect of the new accounting standard. However, if “that effect is still unknown, then in addition to making a statement to that effect, a registrant may consider advising investors when that assessment is expected to be completed. The disclosures should be designed to provide useful information to investors who need time to analyze the impact on companies.”
Schnurr contends that “the implementation of the standard in a manner that results in consistent outcomes globally is a major challenge.” The staff is consulting with companies regarding their specific revenue recognition policies and continuing to monitor the consistency of application of the new standard in the U.S. and internationally, but “will respect the different reporting outcomes that are appropriately supported by the words in the standard and the intent of the Boards….The staff also considers how the new revenue standard was intended to change existing practices, as well as the consistency of proposed revenue recognition for similar transactions within and across industries. The staff is also evaluating the effect of the new revenue standard on existing Commission and SEC staff guidance,” and has indicated that, and will continue to monitor whether, some prior guidance would no longer apply once the new standard has been implemented.
Implementation of the new revenue recognition standard will likely also implicate internal control over financial reporting (ICFR), as companies develop new or redesign business processes, systems and controls. Schnurr believes that a successful transition will largely depend on effective ICFR, particularly management review controls, which can involve significant judgment. Schnurr contends that the new standard should provide
“an opportunity to be proactive and improve the design and operation of management review controls that may exist within a company’s revenue recognition process, including with reference to the various estimates and judgments that the new revenue standard may require….For example, when designing a management review control around estimates of royalties and milestone payments to be included in the transaction price, it will be important to specify: (i) the objective of management’s review, (ii) the frequency and granularity with which management’s review is performed, and (iii) the specific thresholds for investigating deviations from expectations as well as how those expectations are developed. It will also be important to consider the interactions between the review control and other controls, including controls over the reliability of the information used to perform the review. And last, but not least, maintaining appropriate documentation of the effective operation of these controls will be key to their assessment by auditors.”
Schnurr also observed that, in addition to “business process-level controls, it is also important to keep in mind the other four components of internal control over financial reporting, including control environment and risk assessment. For example, availability of competent resources trained to exercise sound judgment will be essential to the consistent, reliable application of the new revenue recognition guidance.” The staff is also continuing to focus on ICFR generally, Schnurr advised, especially in light of the deficiencies in the audits of ICFR that the PCAOB has identified, which “may be, at least in part, indicative of deficiencies in management’s design or operation of controls, including management review controls.” The staff is continuing “to encourage regular discussions between management, auditors, and audit committees on existing and emerging issues in assessments of ICFR.”
Schnurr also delivered the now familiar exhortation that non-GAAP financial measures should not be treated as a substitute for GAAP. Although, as long as they are not misleading, NGFMs are permitted to supplement information from the financial statements, the “SEC staff has observed a significant and, in some respects, troubling increase over the past few years in the use of, and nature of adjustments within, non-GAAP measures by companies as well prominence that the analysts and media have accorded such measures when reporting on the results of the companies they cover.” SEC Chair Mary Jo White has very recently given similar warnings. (See this PubCo post.)
Part of the concern stems from the treatment of NGFMs by the media, which, Schnurr asserts, “very frequently report the non-GAAP measure of earnings with no reference to the actual GAAP earnings, often not even identifying it as having been adjusted.” But he is also “particularly troubled by the extent and nature of the adjustments to arrive at alternative financial measures of profitability, as compared to net income, and alternative measures of cash generation, as compared to the measures of liquidity or cash generation. In my view, preparers should carefully consider whether significant adjustments to profitability outside of customary measures such as EBITDA or non-recurring items or other charges to the business, such as the sale of portions of the business in order to provide the user with an understanding of how these events impact trends and future performance, are appropriate. As it relates to cash measures, I believe those measures should be reconciled to cash flow from operations.”
Corp Fin staff “will continue to be vigilant in their review of the use of these measures for compliance with the rules. The proliferation of non-GAAP reporting measures among registrants, and reliance and reporting by analysts, should warrant increased focus by management and the audit committee. I believe the focus should go beyond determinations that the measures comply with the Commission’s rules and include probing questions on why, in contrast to the GAAP measure, the non-GAAP measure is an appropriate way to measure the company’s performance and is useful to investors. In addition, companies should ensure that the measure is prepared in a manner that includes appropriate controls and oversight procedures.”